are some firms more profitable than others?
A firm's profitability depends on more than just how well
it's run. Some
well-managed firms make very low profits, while some
poorly-managed firms make very large profits.
A firm's profitability depends in part on whether other
firms can easily enter its market and compete with it.
When other firms are free to enter a market, economic
profits tend to very low, even for well-managed firms.
When firms are prevented from entering a market, economic
profits can be quite high.
Economic profits are the difference between a firm's
revenue and opportunity cost.
A firm doesn't need to earn any economic profits at all to
be willing to stay in business.
Such a firm would still be covering all its opportunity
costs, or doing just as well as it could if it used its resources
in their best alternative use.
Economic profits, then, are like gravy for a firm, more
than enough to keep it in business.
As such, they serve as a powerful incentive to enter a
market, luring entrepreneurs who are hungry for opportunities to
But as new firms enter markets in search of economic
profits, existing firms are forced to compete by lowering their
prices and making do with fewer customers.
This eats into the economic profits of all firms in the
market. It's only
after these profits have been almost completely devoured that the
process of entry stops. Hungry
entrepreneurs will then pass over the now unprofitable market in
search of new opportunities.
For example, when video rental stores first started popping
up in the early 1980s, many of them made a lot of money.
Other people quickly caught on that this was a profitable
opportunity, and opened their own stores.
By the late 1980s, video stores seemed to be everywhere,
competing desperately for customers with low prices and speedy
service. Now that the
economic profits have been squeezed out of most video rental
stores, entry by new firms has slowed to a trickle.
As long as new firms are free to enter a market, they will
drive down economic profits. Yet
in many markets, firms continue to enjoy large economic profits
year after year. Something
must be preventing eager new firms from entering these markets.
New firms can be prevented from entering product markets by
barriers to entry.
Barriers to entry are advantages that existing firms have
over new firms wishing to enter a market.
What are these advantages?
When inventors or firms develop new products, they can
apply for patents.
A patent prohibits others from selling a product for a
period of seventeen years. By
insulating inventors from competition, patents enable them to
charge higher prices and make large economic profits.
Patents foster new inventions by rewarding inventors for
the expense and risk of bringing a new product to market.
In the same way, writers, artists, and musicians can copyright
their work. Copyrights
give their holders the exclusive right to reproduce things like
books, plays, software, films, songs, and paintings.
As with patents, this rewards the copyright holder by
protecting her or him from competition.
Federal, state, and local governments sometimes restrict
entry into markets by requiring firms to have licenses.
The Federal Communications Commission, for example, grants
licenses to radio and television stations; there simply aren't
enough frequencies for an unlimited number of firms to broadcast
in any area. For
safety reasons, all nuclear power plants are licensed as well.
Governments also bar entry by giving firms exclusive rights
to a market. The U.S.
Postal Service, for example, has an exclusive right to deliver
first class mail. Firms
are sometimes given exclusive rights to do things like operate gas
stations along toll roads, produce electricity, or collect garbage
in a city. Exclusive
rights are granted if a government believes that there is room for
only one firm in a market.
Until the 1980s, the federal government also restricted
entry into the airline, trucking, banking, and telecommunications
industries. Many of
the laws that restricted entry into these industries were put into
place in the 1930s, when many people believed that large firms
needed to be protected from "cutthroat competitors."
Many economists now believe that these laws did more harm
In 1938, for example, the Civil Aeronautics Board, or CAB,
was established to regulate the airline industry for interstate
flights. For the forty
years that it existed, it didn't allow a single new firm to enter
the market, although it received over 150 applications for routes.
In 1978, despite protests from the airlines, President
Carter ordered the deregulation of the industry and the phasing
out of the CAB. Within
five years, 14 new firms entered the industry.
Many experts believe that airline fares after deregulation
were well below what they would have been had regulation
Often a large firm can produce a good at a lower unit cost
than a small firm. The
Oakdale Foods Corporation, for example, can produce a jar of
strawberry jam for much less than Mrs. Montoya, who produces a
hundred jars a year for her family and friends.
Unlike Mrs. Montoya, Oakdale Foods buys its glassware,
sugar, strawberries, labels, and pectin wholesale, and gets
quantity discounts. Oakdale
Foods also uses large, labor-saving equipment to cut costs; since
Mrs. Montoya makes jam only once a year, it doesn't make sense for
her to buy a lot of specialized equipment.
Oakdale Foods also has highly trained and specialized
workers; Mrs. Montoya has to consult the jam recipe from time to
When a firm can cut unit costs by expanding its size, or
"scale," we say that it is experiencing economies
of scale. Because
of economies of scale, huge factories are usually built to produce
goods like automobiles, computer chips, and refrigerators.
If you wanted to go into business producing any of these
goods, you would need to spend millions of dollars to build a
factory large enough to enable you to compete effectively.
Since most of us don't have─and
can't borrow─that much money,
we are prevented from competing in those markets.
Sometimes firms are prevented from entering a market
because they can't obtain a resource critical to production.
For example, Alcoa Aluminum used to have control over the
world's supply of bauxite, which is used in producing aluminum.
Without bauxite, other firms were unable to produce
aluminum, and Alcoa had the market to itself.
Anacin once advertised that it's "strongest in the
pain reliever doctors recommend most," and that it contains
"what 2 out of 3 doctors call the greatest pain fighter ever
is this miracle pain reliever?
It's acetylsalicylic acid, more commonly known as aspirin.
Most of the aspirin consumed in the
is produced by two
firms, Dow and Monsanto. These
firms sell the aspirin in powdered form to drug companies, which
add inactive ingredients like cornstarch to it, then press the
mixture into tablets. The
tablets are then sold in retail stores under hundreds of different
Even though all aspirin is virtually the same, prices vary
advertised brands like Anacin and Bayer are up to six times as
expensive as unadvertised store brands.
Yet the more expensive brands are bought by millions of
consumers each year. This
may be due in part to misleading advertising; Bayer, for example,
used to claim that "[a]spirin is the best pain reliever and
Bayer is the best aspirin."
A federal judge later ordered the advertisements stopped
when Bayer was unable to prove that it was indeed the best
Advertising is designed to make consumers loyal to certain
brands, like Bayer, Coke, Snickers, and Calvin Klein.
If this "brand loyalty" is strong enough, it can
act as a big barrier to entry.
In order to launch a new product on the national market,
for example, firms sometimes spend over $100 million on
advertising in order to coax consumers away from their favorite
brands. Since eight
out of ten of these attempts fail anyway, few of us can put
together the necessary resources to enter markets in which firms
American firms aren't the only ones hungry for economic
profits; foreign firms wish to compete in our markets as well.
Domestic firms often try to impede the entry of foreign
firms by asking Congress for protection from foreign competition.
Protection usually comes in two forms:
taxes on foreign imports, which make them more expensive
compared with domestic goods, and quotas on the number of foreign
goods that can be imported.
If domestic firms can be protected from competition with
foreign firms, they're able to charge higher prices for their
then, is in the interest of the firms seeking it, but not in the
interest of their consumers.
Economists classify markets according to how much market
power is exercised by the firms in them.
At one extreme are markets with few barriers to entry.
These markets usually have many firms, each with very
little market power. At
the other extreme are markets with such large barriers to entry
that only one firm exists. Such
firms have the potential to wield enormous market power.
Many markets have few barriers to entry, and lots of small
firms invariably spring up. It
doesn't take a lot of money to open a small business like a
Drive-In, restaurant, hardware store, clothing factory, or
barbershop, and millions of people have started these kinds of
firms in their quest for economic profits.
These kinds of markets are relatively competitive, or free
from the use of market power.
It's hard, though, for a business to make large economic
profits in a competitive market.
A restaurant, for example, can't increase its prices by
much without losing customers to other restaurants.
And if a restaurant is lucky enough to do well, people take
notice and open others nearby.
Even well-managed restaurants are often doomed to low
Brutal as these markets are to the firms in them,
competitive markets are the favorites of economists.
Since the rigors of competition weed out firms that are
poorly managed, competitive firms are strongly motivated to find
ways to cut costs. Lower
costs and lower economic profits mean lower prices for consumers.
Best of all, economists have found that these markets are
very efficient at allocating resources.
Among the most competitive markets of all are those for
agricultural goods. There
are tens of thousands of wheat producers, for example, and none of
them has any market power whatsoever.
In fact, wheat farmers don't even need to think about what
price to charge; the price of wheat is determined by supply and
demand, and farmers simply look up the price they will get for
their crops in the financial section of their newspapers.
The word "oligopoly" comes from two Greek words:
oligo, meaning "few," and polein,
oligopoly, then, is a
market dominated by a few sellers.
The automobile, tire, cigarette, airline, and steel
industries are examples of oligopolies.
Many seemingly competitive markets are in fact
example, Tide, Dash, Dreft, Ivory Snow, Bold, Oxydol, Cheer, and
Gain detergents are all produced by a single firm, Procter and
Gamble, and most of the other detergents on supermarket shelves
are produced by just two other firms, Colgate-Palmolive and Lever
The dominant firms in an oligopolistic market often have
large factories, huge advertising budgets, patented products, and
control over raw materials. These
barriers to entry make it very hard for new or smaller firms to
compete with them.
Since oligopolies are insulated from competition, they are
able to exercise market power and raise their prices above what
they would be in a more competitive market.
But they have to be careful.
Since there are other producers in the market, a firm that
raises its price too much may lose some of its customers to
Of course, a firm can raise prices and keep most of
its customers if all the other firms in the market also raise
their prices. That's
why there is such a strong temptation for firms to collude, or
agree not to compete. Collusion
is illegal in the
, and corporations that
are convicted of colluding are fined and their executives
sometimes sent to jail.
Whether or not they collude, oligopolies often earn
substantial economic profits.
This isn't necessarily a result of shrewd management;
sheltered as they are from the stern discipline of competition,
even mismanaged oligopolies can make good profits.
Because of this, many economists wonder if oligopolies are
as diligent about cutting costs as competitive firms.
What also bothers economists is that oligopolies are
inefficient at allocating resources.
Market power enables oligopolies to charge prices that are
well above their marginal costs of production.
As we'll see in a moment, this means that worthwhile trades
are not being made in these markets, trades that would benefit
both parties. Nothing
riles economists more than to see an opportunity to make a
worthwhile trade go unexploited.
The price of Sheila's favorite soft drink, for example, is
40 cents per can, but the marginal cost of producing it is only 10
cents. Sheila consumes
only one soda a day; the marginal benefit to her of a second can
is only 30 cents, so she doesn't buy it.
And here's where an opportunity for a worthwhile exchange
arises. If the soda
firm sold Sheila a second can for, say, 25 cents, both of them
would come out ahead. The
firm would end up selling a soda for 15 cents more than it cost to
produce, while Sheila would end up paying 25 cents for a soda that
gives her 30 cents worth of benefits.
The soda firm would never go ahead with this deal, of
course. If it charged
Sheila a lower price for a soda, then all its other customers
would demand lower prices too, and the firm's profits would be
preserving the profits of oligopolists in this way is costly to
believe that oligopolistic markets thwart billions of dollars of
worthwhile trades each year.
Since the cost to society from market power is so high, our
government strives constantly to increase competition in
oligopolistic markets. The
Federal Trade Commission and the Justice Department enforce antitrust
laws, or laws designed to foster competition.
Antitrust laws prohibit collusion, and also forbid mergers
that greatly reduce competition.
A merger occurs when one firm buys the assets of another
firm in order to make one large firm.
Mono is Greek for "one," and a monopoly
is a market in which there is only one seller.
The markets for electricity, Polaroid cameras, local
telephone service, and postage stamps are all monopolistic.
As the only seller in a market, a monopoly has the ability
to wield enormous market power.
With this market power, a monopoly can set its price well
above the marginal cost of production.
This enables the firm to earn large economic profits, but
it's inefficient. As
we saw with oligopolies, setting the price above the marginal cost
of production prevents worthwhile trades from taking place.
In spite of this, the government often allows monopolies to
exist. Thanks to
economies of scale, a monopoly can often produce output much more
cheaply than several smaller firms can.
For example, it's cheaper to build a single 1,000-megawatt
nuclear power plant than two 500-megawatt plants.
And allowing just one firm to provide a service to all
customers in an area can sometimes avoid duplication of effort.
It wouldn't make sense to have several mail carriers
delivering letters to each house, or several bus firms covering
the same route.
To protect consumers, governments often try to control the
market power of monopolies. One
way to do this is is through regulation.
A regulatory agency typically will give a privately-owned
firm exclusive rights to a market, but regulate the firm's prices
and standards of service. The
agency usually sets the price so as to give the firm a modest
Regulating a monopoly's profit prevents it from exploiting
its market power, but it causes other problems.
Most firms are eager to cut costs so that they can earn
more profits. But if a
regulated monopoly succeeds in cutting costs, its regulatory
agency will often take away any excess profits that it makes by
forcing the firm to lower its price.
This means, of course, that regulated monopolies don't have
much incentive to cut their costs.
To correct for this, regulatory agencies often monitor
their operations carefully to make sure that they're being well
A second way to control the market power of monopolies is
in which the government owns and operates the monopoly.
Examples of nationalized monopolies in the
include the U.S. Postal
Service, most municipal transportation systems, and the Tennessee
Valley Authority, which supplies electricity to several
Like regulated private monopolies, nationalized monopolies
lack the incentive of profits to spur them to cut costs.
Nationalized monopolies turn any profits they earn over to
the government; if they lose money, taxpayers make up the
When a monopoly is the result of a patent or copyright, the
government usually allows the firm to charge whatever it wants for
its product despite the inefficiency that results.
Fortunately, these firms are still under some pressure to
keep prices down. Take
, which has an exclusive
right to sell DVDs of the movie The Longest Yard.
It knows that if it charges too much, consumers will simply
buy other movies, or not buy any movies at all.
charges higher prices
than it would in more competitive markets.
© Lori Alden, 2005-7. All
rights reserved. You may download the content, provided you
only use the content for your own personal, non-commercial use.
Lori Alden reserves complete title and full intellectual property
rights in any content you download from this web site. Except as
noted above, any other use, including the reproduction,
modification, distribution, transmission, republication, display,
or performance, of the content on this site is strictly